The Fiducia Winter Webcast

Interviewer: I’m delighted to welcome regular followers of our webcast and, I hope, those that are viewing for the first time. This is the first conversation of 2015 with Michael Hughes, who is an economic and investment consultant. Michael, welcome.

Michael: Thank you.

Interviewer: Thank you again for your time. We should at first just look back at 2014 in terms of how events unfolded, what their effect was, what sort of year it was in investment terms.

But then looking at 2015, we’re only three weeks into the new year, but there seems to be plenty to talk about and consider. We’ve certainly continued falling in the oil price, which is obviously significant, we’d expect, in terms of its effect on global economy. The Swiss National Bank took everybody by surprise with their ending of the Euro Peg maybe even the ECB simply considering doing QE as well as that stuff for all this time. And of course we are already into the early activities with the election. And that may well have effect upon markets as well. So I’m sure that’s only a few of the things that you’re going to cover for us.

Michael: Good. Okay. Well, perhaps if we start with 2014, because there was a positive bit and a negative bit. If you look at the investment returns for 2014, they were pretty subdued. And even high risk payers, risktakers, were not paid a great deal more that those who were pretty cautious. So it was very flat year and in contrast to the previous two years. And the negative aspect of 2014, which had been worrying us, was that there were likely to be some negative surprises. And the most negative surprise was our expectations for economic growth were going to change.

Now. as we got into 2015, places like the World Bank, the IMF, forecasters generally, have been taking their forecasts for growth down. So those negative surprises have, in many ways, now been reflected in the market.

Also, we were, perhaps, concerned that there may be negative surprises in terms of monetary policy, in other words the ending of QE in the States, and more importantly, the lack of any real QE, quantitative easing, for Europe. And as we’ve seen, there’s now a real concern that Europe is going into a deflation, with falling prices, which where you have large amounts of debt, isn’t the best place to be. So to some degree, it was a negative aspect, which I think markets were proving to be pretty cautious about.

The positive side of 2014 was that you began to see some major reform programs in part of the big Asian economies. You saw it after the elections, and the reform program that’s been rolled out there looks pretty impressive. You started to see it in Japan. And you continue to see it in China, but we know that China is a much longer story. And indeed, if you look at the returns for sterling investors last year, the Shanghai Chinese stock market was up nearly 70%, and the Indian stock market was up by more than a third.

So even though people think it was a pretty flat year generally, and particularly for emerging markets, actually, within emerging markets, particularly in the Asian part of emerging markets, there were some, actually, very positive returns. So there’s a positive element to 2014 and obviously a negative element.

Interviewer: What you were saying about those returns in China and India in particular. That’s before, sort of, currency movements.

Michael: No. That’s in sterling terms. So that allows for what happened to currency. But you contrast that with Russia, for example, which was down more than 40%. And Malaysia was down and Brazil was down. So all the oil exporters or the commodity census barriers were badly hit. But those who are beneficiaries of that and were undertaking major reform programs, then, by and large, investors did well out of those.

Interviewer: So no more pains?

Michael: No. I think going into 2015, the Asian story will continue, because by admission, the reform programs there don’t happen overnight. They are continuing in India. There certainly continuing in China and Japan. And you’re beginning to see them elsewhere, in Korea, in Indonesia, because, by and large, in a competitive environment, and these are the areas of the world that are the fastest growing and arguably will be the biggest in years to come, they need to have a private sector and a capital market that can keep pace with the size and development of their economy. So to some degree, capital markets have been lagging behind. But the reform program is something which actually helps them to catch up.

So I think it’s possibly important, still, to have an Asian focus within the portfolios, because there’s a lot going on.

Interviewer: No doubt that you’ll comment later. They’re all beneficiaries of the reduction in the price of oil.

Michael: They are. And we’ve had virtually a holding of the oil price. It looks is that though it’s more to do with supply than it is demand, because although there’s a sensitivity about demand falling away, at least in places like China, not a lot of evidence that’s happened. Whereas if you look at the supply coming in and out in the States, with fracking, if you’ve seen what Saudi Arabia and the OPEC generally are doing, quite apart from Iraq and Libya trying to put more oil back on the market to rebuild their economies, so the supply side has been much more effective, I think. And because of that, the relatively lower oil profits, I think, it’s going to be with us for a while. Now, that is a big boost to the global economy.

Interviewer: I’ve seen some amazing numbers that have been quoted recently.

Michael: Well, the range of the boost to economic growth goes from a half percent to 2%. But either way, it is a boost. And even in areas that have been suffering, or at least Europe, for example, that’s a very necessary boost, because it comes at a time, obviously, demand generally, has been pretty weak, and the ability to boost living standards and to boost corporate spending is clearly very important.

Interviewer: When you said its about supply, and it appears to me, from what I’ve read generally, that it’s all about market share in the OPEC countries in particular, in the Middle East. They don’t want to lose market share. So they are in this for the long stay.

Michael: Exactly. I think a lot of developments that you see are relatively permanent. So I think you can be reasonably confident that a large part in the fall of the oil price will be with us for some time, and hence the boost to the living standards and economic growth is obviously something that we can enjoy for this year. So that’s a positive for 2015.

If we look beyond 2015, I keep making this point, but markets don’t look out a month. They look at almost an amount of years. The question I think we have to ask as investors is that we have built up an enormous amount of debt. In fact, part of the whole quantitative easing program has added to that that burden. And at some stage, we have to deal with it, because we can’t live with this amount of debt. And the only way you can actually reduce debt is either by having more economic growth or allowing more inflation to devalue their debt or indeed, defaulting on the debt.

Now, clearly two of those paths are negative for markets, and one is positive. So I’m going to put a positive spin at the moment and say that I think that positive development is more likely than the two negative ones.

But then you have to ask the question, how do you generate growth? Because in this environment, with large amounts of government debt, governments cannot spend their way out of this environment, or indeed, borrow their way out to market improvement. So you’re reliant much more on companies and, arguably, larger global companies in order to have the incentives to grow. Governments are looking at this, and they have reduced corporate taxes, but there’s a bit of a competition to have the lowest corporate taxes. Equally, we’ve seen technology developed.

But much more importantly, you started to see companies that many of us have never heard of certainly hit the global stage, out of India, out of China, out of Latin America to some degree, and these are the big global players in the future. So one of the investment themes that I think is important, is to try and find those companies, those funds that specialize in finding companies that are the global players in the future and are the source of the economic growth that will help us deal with our debts. That is one of the big investment challenges for 2015 and indeed beyond.

Interviewer: But you expect to see any defaults, because it’s been talked about recently?

Michael: The problem with that default is that it takes many forms. Governments can reschedule their debt, make it longer to repay, and you could argue that actually is a default. And indeed, the ratings agencies will actually count it as a default. But effectively what they’re doing is trying to put off the day of reckoning, so little bit of wiggle room, if you like, to that.

But yes, I think there will have to be a fair degree of rescheduling and a degree to which the larger players, or at least in Europe, I’m thinking of Germany, will basically have to say, “No. We’re preparing, actually, to forgo some of the debts of our neighbouring countries, because they’re never, realistically, going to get out of this hole if we don’t actually reduce their debt burden. So I think there’ll be an element of debt forgiveness as well.

Interviewer: So because of that, what’s being talked about informally at the moment about QE action happening in Europe? I mean, do you see that happening now?

Michael: I think it’s inevitable that you will now get, given that the European Court of Justice has given the approval for the sort of bailout that has been proposed a little while ago, which hasn’t yet happened, now that they’ve effectively giving the formal approval to that, then I think the ECB will provide some support.

However, the ECB always does it with conditions. It’s never as straightforward and as open-ended, as you’ve seen in Japan or indeed the States and U.K. So the conditions attached to it, may still be part of the ECB’s need to be able to ensure that they are abiding by their original Constitution. So I don’t think it’s going to be as full-blooded.

Much more importantly, I’m not sure it’s going to work as well as it has elsewhere, because most of the funding for the small and medium-sized companies in Europe, actually comes from the banks. It doesn’t come from the capital markets.

Very different in the States. So the quantitative easing in the states provided a boost to capital markets and provided, therefore, a boost to corporate sector in the states. The mechanisms in Europe are very different, and hence, I’m not so convinced it will be quite as effective. But time will tell and either way, we have seen a very big support program coming out of Japan, and in some degree, the U.S. and the U.K. are in no rush to unwind any support that they’ve given.

Interviewer: But in terms of the election in the UK, obviously it’s going to be a close run thing. Markets don’t like uncertainty. But in terms of how they look forward on this, what’s your take on it?

Michael: I think it’s pretty unpredictable. You got so many different permutations, coalitions, and I think it’s impossible to judge voting habits of the UK electorate in this environment.

Interviewer: Does it matter in economic terms?

Michael: I think it does matter. It matters for several reasons. Firstly, because you want some degree of certainty about policy making, and the idea of having another coalition where you have, not weak government, but you have diluted policies . . . I mean, we really need another term to get rid of the debt or reduce the debt. That, I don’t think, will go down well in markets.

Plus, the other thing which I think needs to be borne in mind, is you have seen currencies come down dramatically. The yen has come down. Obviously, you seen the euro come down. Actually, the sterling hasn’t come down a great deal, and although people can think of it being in the 170s against the dollar a little while ago, it’s now on the 150s. Actually, sterling isn’t cheap. To really be cheap, you’re looking at something that has to be in the 130s and 140s.

So my fear is that if you have greater policy uncertainty because of the election, that it will be sterling that suffers, and hence that U.K. bonds particularly, relative to overseas bonds, won’t look as attractive. And hence, you will see that it is part of the U.K. markets, which have been, in the course of 2014, starting to underperform, I fear that will actually continue into 2015. But much more so, I’m concerned about what may happen to the currency.

Interviewer: So when you roll all this into the decisions that we make in terms of, I guess, the portfolios of clients, how should we see that influence in those decisions that we make in the longer term?

Michael: To some degree we already have prepared for this scenario. Our holdings in overseas bonds are higher than those in U.K. bonds, and in some of our portfolios we don’t have any U.K. bonds at all. Where we do, we prefer the index-linked to the conventional bonds. So we’ve got a defensive strategy for the U.K. in place.

We are still looking for exciting new funds to play the new global players, and some of those have been found, and I hope we’ll find quite a few more of those over time. And the Asian play that we’ve built-in to portfolios, I’m pretty comfortable keeping in in 2015.

And the only difference, I guess, is that whereas last year we were relatively defensive, we weren’t concerned about negative surprises, I’m more minded to think there may be one or two positive surprises in 2015, possibly away from the U.K. rather than in the U.K., and I think that we can reflect that in our portfolios this year.

Interviewer: Michael, thank you ever so much. Thank you for joining us, and we look forward to seeing you again the next time we meet Michael.

Michael: Thank you.

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